Tuesday, May 29, 2012

I recently met one of the most interesting persons, let alone entrepreneurs, I have ever met: Emerson Spartz, the founder and CEO of Spartz...

I recently met one of the most interesting persons, let alone entrepreneurs, I have ever met: Emerson Spartz, the founder and CEO of Spartz Media. If you have not previously heard of Emerson, trust me, you surely will. This guy is destined for continued success, and is driven by an infectious energy, a terrific intellect that runs at light speed and a real desire to "change the world".

But, what makes Emerson's story particularly interesting, was the fact he started Spartz Media in 1999, at the ripe old age of 12. Yes, I said 12, with Spartz Media the brainchild of a good student with an unparalleled sense of curiosity about the world, who decided to drop out of the 7th grade to follow his passion at the time: building the #1 fan site for Harry Potter fans, called MuggleNet.

With the support of his parents, two successful professionals of their own, they agreed to let Emerson start the business and continue his education as a home-schooler in their home town of La Porte, Indiana, where Emerson could customize his own curriculum. His parents incentivized Emerson to read as many books as he could, including an economic reward of "a penny a page". Emerson read 1000's of books about everything and anything that interested him, from fiction (books from Grisham, Cussler, Follett and Clancy) to non-fiction (the biographies of four famous people a day). Emerson was a sponge for knowledge, and was driven by the mantra: "brains + money = smiles to infinity".

Without the help of any mentors, Emerson built MuggleNet into the dominant fan site in its space, generating over 9MM visitors per month, at its peak. He did this by: (i) hustling for new users (via link trades with the other Harry Potter focused sites); (ii) accumulating over 120 volunteer content contributors for the site; and (iii) following the example of other fan sites as role models (e.g., The Simpsons, Lord of the Rings), which had built up professional businesses in their space. Emerson was taught at an early age by his parents that "can't" was a four letter word in their house, and he was constantly looking for new ways to innovate and succeed (hiding his young age from potential partners).

Emerson's MuggleNet success turned him into a celebrity within the Harry Potter world. He published three books, went on book signing tours in 35 cities across the country and even had the honor of being asked to fly to Scotland in 2006 (at the age of 18), to meet J.K. Rowling, the author of the Harry Potter books, who wanted Emerson's assistance in helping her promote her newest and sixth book in the series. Like Harry Potter, Emerson had the magic touch, and had become the voice of Harry Potter fans worldwide via the MuggleNet website, podcasts, games and content.

But, Emerson was also craving the social experience of going to college, and handed off the day-to-day CEO job at MuggleNet to his team, and enrolled at Notre Dame in 2005. But, Emerson was less concerned about getting good grades (which he did anyway), but again was driven by a desire to customize his own curriculum, trying to learn how people and business really behave and work. Emerson studied an eclectic mix of subjects, including neuroscience, memory, business, politics, psychology, science, SEC filings and over 60 industry research reports from natural gas to drywall contracting.

Emerson was hunting for any patterns in commerce behavior, which he could practice and apply in real life. He built frameworks around various topics, like persuasion, negotiation and innovation, and created scripts and tactics in the real business world. He was trying to build a repetitious practice regime for business, very similar to the practice regime he applied as a sports athlete while playing golf or basketball, to sharpen his skills.

After graduating from Notre Dame in 2009, he settled back in the CEO chair at Spartz Media, where he launched over 18 other website properties, the largest of which is OMG Facts, the #1 random facts website and video series (with over 33MM views on YouTube to date). In the last two years, this collection of websites has grown to over 10MM unique visitors and 160MM page views per month. And, the Spartz Media business has grown to millions of dollars in revenues and employs over 30 employees today.

In addition to his unique education, Emerson's success at Spartz Media is driven by the fact that he has figured out how to easily identify gaps in consumer content demand, build content/communities in those verticals and ignite the viral buzz. He said the magic to making something go viral is to: (i) remove any barriers that impede virility (give users the tools they need); (ii) plant the seeds with the highest demanded "fat tail" content (tested ahead of time in small sample pools); and (iii) repeat the process in other like-minded communities.

This model has led to an unbelievable 95% success rate for each site launched, with success defined as over 1MM page views per month. And, going forward, Spartz Media is reapplying this process by launching one new site per month in new categories. Not dissimilar to the strategy Zynga uses to launch new viral video games, or the strategies Demand Media employed to grow their content-centric business. Emerson acknowledges that a "trends-based" content strategy may lead to user decay over time as the trend passes, but the rapid launch of new sites more than offsets any traffic losses from the old sites. In addition, he looks for other out-of-the-box ideas that can generate "long term legs" of their own, and is currently working on two such sites, one for High School Memes and the other a World Records site.

Emerson, may or may not raise outside capital to help him accelerate his efforts or make some acquisitions, but he has the luxury of deciding his own fate, as the current business is profitable based on his successful advertising sales model (which still has plenty of upside in front of it, by building an internal sales team instead of relying on third party resellers). Emerson equates Spartz Media very much to a VC-backed startup incubator, funding and launching a bunch of "high odds of success" sites, to see what sticks.

So, there are a lot of interesting startup lessons for us all: (i) don't be bound by the current way of doing things (think out-of-the-box to customize your own solutions which you can be passionate about); (ii) if you don't have your own mentors or skills, look to similar case studies as role models of where to go and read up on those topics; (iii) once you have figured out your "magic sauce", look for new ways to apply those skills for new products and "hit the repeat button".

Honestly, Emerson Spartz is a case study that Arne Duncan, the Secretary of Education in the U.S., needs to learn about, so our country's broken education system can be retooled to actually produce entrepreneurs like Emerson, who are helping to create jobs and drive our economy at such a young age. Hey Chicago, anybody we know that can help Emerson with that introduction??

Fenwick & West, the big Silicon Valley law firm, publishes an annual Seed Financing Survey in recognition of the growing importance of seed financing to entrepreneurs and the venture capital environment, especially in the internet/digital media and software industries. Below is a summary of the results, based on studying 56 transactions in 2011 and 52 in 2010.

Overview of 2011 Seed Financing Survey Results

The use of convertible notes increased by 10 percentage points (to 41% of deals), and likewise the use of preferred stock decreased by 10 percentage points (to 59% of deals).

The median size of convertible note deals increased from $662,500 to $1 million, while the median size of preferred stock deals remained basically flat around $1 millon.

The pre-money valuation in preferred stock financings increased from $3.4 million to $4.0 million for internet/digital media deals, and from $2.7 million to $3.5 million for software deals.

The median valuation cap on convertible notes increased from $4.0 million to $7.5 million. Notes are capped 82% of the time.

If notes are repaid prior to next financing, they are typically repaid at 2.0x the principal amount, on average ($1 million note gets $2 million if company sold and note repaid).

Notes paid an interest rate of 5.5%, on average, and had a term of 18 months, on average. Notes were typically unsecured (96% of time).

The percentage of convertible note deals that convert at a discount to the next equity valuation increased from 67% to 83%, with that discount being 20% from the next round, on average.

The lead investor was a seed fund (46% of the time), professional angel (28% of the time) or VC fund (27% of the time)

Investors were given a board seat 70% of the time in preferred stock deals, and 4% of the time in convertible note deals.

For purposes of this survey, a "seed" financing is defined as the first round of financing by a company in which it raises between $250,000 and $2,500,000, and in which professional investors play a lead role (excludes financings led by "friends and family", which terms may not be negotiated on an arms-length basis). For this reason, the survey may not be representative of all companies receiving early stage financing, and is likely over-weighted to more promising companies funded by more established seed investors.

Overview of Current Seed Financing Environment

The seed financing environment for internet/digital media and software companies is expanding and becoming increasingly varied. Not only is the amount of seed investing increasing, but the diversity of seed funding sources is also increasing (e.g., friends/family, individual angels, angel networks, incubators/accelerators, seed funds, VC's investing earlier, crowdfunding). With this proliferation of seed capital and diversity of sources, the "leverage" in seed transactions seems to be leaning in favor of entrepreneurs, as preferred stock valuations, convertible note usage and convertible note cap amounts are increasing.

Tuesday, May 15, 2012

Giving up equity in your business, as an alternative to paying cash, often sounds like a great idea to cash starved startups. But, giving u...

Giving up equity in your business, as an alternative to paying cash, often sounds like a great idea to cash starved startups. But, giving up equity in your business is often a very big decision, and can come at a long term price, both financially and operationally. This lesson will help you figure out when it is appropriate to trade equity for services, and when you should avoid it. As, well as certain potential pitfalls along the way.

To me, this decision often comes down to: (i) how easily can you source capital from professional investors to pay for the services; (ii) how big of a cash requirement is the project at hand; (iii) are services long term or short term in nature; (iv) how onerous are the terms; and (v) are there any other potential strings attached. Let's tackle these points below.

When you can, raising capital from a professional third party investor is always preferred. You always want to raise cash from equity investors with experience in building startup businesses, often with a rolodex of potential business contacts and lessons learned from their past investments. Taking cash from a service provider is often just that . . . cash only. But, if you have no other alternatives from professional investors, service providers can be a perfectly acceptable financing resource for you, if that is all you need and it is structured fairly.

I wouldn't be giving out equity to any and all service providers. You should be holding your equity near and dear to your heart, and only giving it out when absolutely necessary. The higher percentage of your company that you can retain over time, the higher your payday will be when you hit it big on the backend. So, when considering trading equity for services, I would limit such to material projects of scale (e.g., financial benefit of in excess of $50,000 in savings).

And, on a similar note, I would limit equity conversations to service providers that are going to be long term in nature, helping you build your business over time. For example, your tech development firm that is going to help you build your website and maintain it over time, is a much better equity partner than the firm that is going to design your logo in a quick one time project.

Now that we understand which service providers we are willing to have equity conversations with, next we have to understand how to structure these deals. This typically comes down to the security, voting rights and valuation of the deal. For the security, shoot for convertible note or common stock deals where you can, so no preferred stock requirements impede your ability to raise future capital. For voting rights, it should be capped at their pro rata ownership in the company, and typically should not require any seats on your board of directors (allowing you to run the business as you see fit).

For valuation, whatever cash savings you are realizing, should be invested at a reasonable company valuation. For example, let's stay your startup is worth $1,000,000. If you are getting $100,000 in cash savings from the service provider, they should get around 10% of the company. So, make sure the percentage they are asking for is fair, in relation to your valuation. And, always be sure the project is well-defined and the project size is capped, so project creep doesn't have you giving out twice as much equity as you originally planned.

Finally, make sure there are no strings attached and avoid other known potential pitfalls. Things like: (i) it is difficult to keep a service provider managed on time and budget, when they are also an equity owner who needs to be treated with kids' gloves (so make sure both parties are clear their role as a service provider, meeting deadlines and budgets, will come first); (ii) make no promises about fund raising prospects, potential buyers or future valuation expectations (let them make their own assumptions, understanding they are investing in a very risky security where the future is unknown); and (iii) make sure there is a clear plan in case things are not going well together (e.g., a way to buy back the stock, keep a copy of tech code or trade out service providers, in all scenarios).

There are many other issues to consider here, but hopefully this is a good high level education to get you started.

Monday, May 7, 2012

The age old debate about what fuels a startup's success is whether they are "driven to win" or have a "fear of failure&qu...

The age old debate about what fuels a startup's success is whether they are "driven to win" or have a "fear of failure". In this lesson, we are going to try and resolve this question, once and for all.

I think both sides of this argument are pretty self-explanatory, but let's just make sure we are clear on what we are talking about here. Being "driven to win" is an insatiable desire to be #1 in your industry, often with a "take no prisoners" mindset of growing market share as quickly as possible. The CEOs of these types of businesses often have a deep disliking of their competitors, and see themselves in a "all-out sprint" against the CEO's of others in their space. On the other hand, "fear of failure" is driven more by not wanting the company to go out of business, and the perceived negative impact that would have on the CEO's resume and reputation. To me, the former feels more akin to an "offensive" strategy, and the latter feels more like a "defensive" strategy.

So, if that is in fact a good analogy, are you aware of any competition that doesn't require the proper balance of both a good offense and a good defense? I really think if you have too much of one, without the other, your success will be hampered. As one example from the sports world, do we all remember the failed Rich Rodriguez tenure as head coach of Michigan Football between 2008-2010. His innovative offense broke every statistically record, as the most productive offense in the 132 year history of this storied program. While at the same time, his lack of defensive focus, broke every statistically record in the wrong direction, as the worst program in the history of Michigan football. This lop-sided mix of skills, resulted in a middle-of-the-road record (7-6 in 2010), and the ultimate firing of Rich Rodriguez at the end of that season.

This analogy holds true in the business world, as well. All offense and no defense, can cripple your company. If you are too scared to fail (e.g, too much defense), that may cripple your ability to innovate out-of-the-box ideas, that if successful, would catapult your business to new heights never before possible. Let's use Apple as an example. What if Steve Jobs had stayed "defensive", focusing on protecting Apple's marketshare as the leader in personal computers. We would have never seen such great innovations as the iPod, iTunes, iPhone and iPad that revolutionalized the tech scene in the years that followed, fueling Apple's meteoric growth and stock price. And, on the flip side, if you try to use too much "offense", you can cripple your business by growing too quickly, or running out of cash, or entering more markets than logically makes sense for your phase of development, stretching your limited resources too thinly to be sustainable.

I think this theory holds true from my personal experience while CEO of iExplore. I was equally focused on "offense" and "defense". I was deeply-driven to win market share and partnerships away from my competitors at the time, like Away.com, Gorp.com, and AdventureSeek. I wasn't going to rest until we had the largest website and most strategic partnerships locked up. While, at the same time, I had a deep fear of failing, especially in the wake of 9/11/2001 and the negative impact that had on the travel industry. I wasn't going to let Osama Bin Laden end my dream or taint my track record, and I fought on through very difficult market conditions, even though the odds of success were not in my favor. Without the "offense", we would have never built up a #1 market position and partnerships with National Geographic, Travel Channel, Expedia, Travelocity, Lonely Planet, Fodors, Frommers, Conde Nast and others. And, without the "defense", it would have been a lot easier to simply file for bankruptcy in 2001, given the uphill battle that laid ahead.

So, it is not whether you are "driven to win" or have a "fear of failure". To me, startup success needs an equal balance of both, for "offense" and "defense".

Learn More about Red Rocket

Red Rocket can help your business "blast off"!! Our Partners are proven CEO's and CMO's, that have already mastered the same growth challenges you are experiencing. We can help you with your growth strategy, execution or financing needs. Learn more at RedRocketVC.com. Or, check out our explainer video and free e-books.

Red Rocket is a featured contributor on entrepreneurship for many trusted business sites:

About

Red Rocket is your "one-stop shop" for growth: we help B2C and B2B companies with their growth strategy, execution team and financing needs. We are particularly deep in the digital technology space, but have done work across industries. We have consulted or mentored over 750 companies, to date.This blog serves as a small business executive's strategic "playbook", with actionable "how-to" lessons on a wide range of topics, including business, strategy, sales, marketing, technology, operations, human resources, finance, fund raising and more. Click the "Lessons 1-202" tab for the full list, or search by topic using the "Categories" tab.